Recalculation in Iceland

As you know, I’ve been critical of “recalculation” models of the US recession. I think it’s mostly demand-side, and some unknown part of the supply-side is government labor market interference. Only a modest portion is recalculation. But Arnold Kling’s model almost perfectly explains the current Icelandic recession:

Economy Minister Arnason wants more for Iceland than fishing and geothermal energy. He acknowledges that the nation got into banking without the right infrastructure or the know- how to do it well. Still, he doesn’t think Icelanders have to go back to fishing now that they’ve proven themselves inept at finance.

His government needs to find work for the 2,000 highly educated finance-sector employees who lost their jobs, he says. Otherwise, they’ll migrate, and a shrinking population is the biggest scourge for this small, isolated island nation.

Some Keynesians might object that it’s also a demand problem; after all, Iceland went through a severe financial collapse, one of the worse in world history. All the major banks failed, with liabilities totaling 1200% of GDP. The housing industry collapsed. Surely that points to a decline in AD?

Actually no. Those Vikings wouldn’t have been able to survive in that harsh climate without having some smarts. Unlike the foolish Irish, the Icelanders decided to let the big banks fail and have the creditors pick up the tab, not the taxpayers. To prevent a fall in AD, they sharply depreciated the kroner. I had trouble finding NGDP data, but if you look at the graph halfway down this link, you’ll see Icelandic NGDP rose continually through the worst of the 2008 crisis, and has continued to move gradually higher. In contrast, Irish NGDP has plunged. Ireland lacks the nominal income to repay its euro debts, and even to pay euro wages without steep wage cuts. Ireland faces both recalculation and a severe demand shock.

The rise in NGDP did not prevent a fall in Icelandic RGDP; their financial collapse was a very severe real shock. Those bankers can’t be immediately retrained as fisherman. The reason Iceland fits Kling’s model so perfectly is:

There was no demand shock

It’s not even clear what the new patterns of specialization and trade should look like. Iceland is groping in the dark (literally, during these winter months) for new industries.

Paul Krugman also has a couple posts on Iceland. In this one he points out that Icelandic RGDP fell about the same amount as in countries with much smaller financial crises, and that employment did considerably better. I see those two arguments as being related. Suppose Iceland had a real shock big enough to reduce RGDP by 15%, whereas Ireland and the Baltics merely had real shocks big enough to reduce RGDP by 8%. But now assume that Ireland and the Baltics also had negative demand shocks, caused by their attachment to a euro that was way too strong for their economies (and indeed a bit too strong even for Germany.)

In that case Ireland and the Baltics might see RGDP declines as big or bigger than Iceland, even though their real shocks were smaller. And this is what happened. This also explains why employment did better in Iceland. Recall that their real shock was much bigger, so for equal drops in employment you’d expect a bigger drop in Iceland RGDP than in the other crisis countries. But we know that the decline in RGDP in Iceland was actually a bit less than most of the others. This is because the good AD policies allowed some fraction of unemployment bankers and real estate people to find jobs in other industries. Those new jobs were at lower levels of (measured) productivity per worker, which explains why RGDP fell more than employment.)

In other words, monetary policy did not slow the process of recalculation in Iceland. In the other crisis countries monetary policy took a bad situation and made it even worse. Unemployed workers in overbuilt sectors were not able to find jobs in other sectors, as total demand was falling.

Scott Sumner has taught economics at Bentley University for the past 27 years.

He earned a BA in economics at Wisconsin and a PhD at University of Chicago.

Professor Sumner's current research topics include monetary policy targets and the Great Depression. His areas of interest are macroeconomics, monetary theory and policy, and history of economic thought.

Professor Sumner has published articles in the Journal of Political Economy, the Journal of Money, Credit and Banking, and the Bulletin of Economic Research.